Money talks: alphabet soup – TFSA Accounts
by Arnold Machel, CFP®
“Cast your bread upon the waters, for you will find it after many days.” – Eccl 11:1 (ESV)
Used appropriately, TFSAs (short for Tax Free Savings Accounts) are an incredibly powerful tool in the arsenal of the financial warrior. Used poorly though, they can be disastrous.
First, the rules…
Since 2009 individuals 18 years or older have been able to contribute varying amounts to their TFSA. The contribution limit is cumulative such that today, for someone who was 18 or older in 2009 and has never contributed, the limit would be $57,500. Currently that limit grows by an additional $5,500 per year. Withdrawals can be taken out and may be re-contributed, but not until the following year.
The name is unfortunately misleading as they may also be used for investment accounts, not just savings accounts. In fact, the rules that govern what TFSA accounts can invest in are identical to the rules for RRSPs, so you can have TFSAs that are truly savings accounts or you can have the funds in GICs and term deposits or mutual funds or even individual stocks; however, investing in individual stocks requires the additional step and costs of setting up a self-directed TFSA.
There can be massive penalties for over-contributing, so be very careful to obey the technical rules to ensure that you do not over-contribute. It can be very easy to over-contribute in cases where regular contributions and withdrawals occur, or if you are unaware that the account type that you have is a TFSA.
You do not get an immediate tax break when contributing to a TFSA, but your money does get to grow tax free and you do get to withdraw the funds tax free whenever you want them. That’s the real power of TFSAs. You never pay tax on the growth of your funds. Not even when they are withdrawn.
Best and highest use
In my opinion TFSAs are best used in two particular situations…
Generally speaking, if you will be in a higher tax bracket in retirement (either because you are making very little now, or you expect that something will happen that will propel your income into a higher level later) then that would favour contributing to the TFSA as your retirement funding vehicle first. The problem is that the limit grows only by $5,500 per year, so for most people the TFSA will not be enough.
Also, generally speaking, if the holding period may be short (like an emergency fund), the TFSA is favoured.
An argument could be made that TFSAs are also the better retirement vehicle option (at least compared against RRSPs) if you expect to be in the same tax bracket in retirement. Mathematically they are in fact equal in that scenario, however the TFSA provides greater flexibility should the need to raise funds arise. But that’s a double-edged sword. For example, pensions are among the best retirement vehicles available, largely because of their lack of flexibility. It’s precisely that lack of flexibility that ensures that they are there for retirement.
There can be additional factors to consider, so be sure to talk to your adviser before committing to anything, but the above will hold true in the majority of cases.
Using TFSAs poorly
From my experience I see two main areas where TFSAs are used improperly. The first is using a short-term savings vehicle when the plan is for the funds to be there for the long term, and the second is accidental over-contributions.
Ask yourself, what will my TFSA money be used for? If it’s for retirement or for passing on to the next generation then it’s likely going to be there for a long time. Don’t use short term solutions (i.e. GICs, savings accounts and term deposits) for long term intentions. Over a year or two or even three, the difference between earning 2% and 5% doesn’t make that much difference, certainly not enough to justify any risk. But if your investments need to last more like 20 years then it makes a massive difference. An amount of $10,000 sitting earning 5% tax free for 20 years will grow to $26,532. Earn only 2% and that drops to $14,859. So, if the purpose of the money is long term, then you can afford a little more volatility and you are likely to be very richly rewarded.
Over-contributions can occur many different ways, but nine times out of ten it’s due either to one not being aware that a limit exists or not being aware of how the limit is determined.
For example, if someone had a $57,500 limit and was to contribute $5,000 per month at the beginning of the month and subsequently withdraw $5,000 per month in the middle of the month, they would be considered to have contributed $60,000 in the year, because they made twelve $5,000 contributions. Even though the account would be empty, they would be considered to have over-contributed by $2,500. One’s additional room does not increase from withdrawals until the following year.
What to do if you accidently over-contribute
Recently a client of mine received an $90,000 inheritance. Believing that he would spend all of the funds fairly quickly, he deposited it into a bank account that he had that already had $35,000 in it. He was unaware that it was a TFSA account and that the limit existed. Unbelievably the bank (one of the major ones) let him do it.
The penalty for over-contributing is 1.00% of the value of the excess contribution per month. Fortunately, we happened to catch this bank oversight, but not until the following month, so because he was over the limit by about $70,000 for two partial months, he is facing a penalty of about $1,400 ($700 for each month he was over).
So what steps should my client take? Step 1 is to withdraw the excess funds as soon as possible. Step 2 shouldn’t be taken until a notice is received from CRA. At that time, write a really nice and contrite apology letter to CRA explaining how the mistake occurred, what has been done to fix it and what has or will be done to ensure that it won’t happen again. Include with the letter a cheque for any penalties assessed.
It’s been my experience that CRA has been quick to waive penalties. They haven’t in every instance that I’ve seen, but they have in most of the cases, so it’s certainly worth your time to write the letter.
TFSAs should not be the main investment vehicle for every person, but just about every person should have at least a little bit in TFSAs. Figure out what is right for you and get help if you are not one hundred percent sure.
Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at firstname.lastname@example.org or through his website at www.visionvest.ca. Please note that all comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of IPC Investment Corporation. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.